India carve-outs: A larger slice

Large-scale mergers inevitably generate smaller ripples as assets are divested to appease regulators and the unification of cement giants Lafarge and Holcim was no exception. Announced in April of last year, it took more than 12 months for the deal to close, with competition authorities in India, Europe and North America the last to grant approval.

The Indian authorities - concerned that the merger of two companies with a combined global market value of $50 billion and a combined domestic cement capacity of 68 million tons would undermine competition - made two requirements: Lafarge had to sell one cement plant and one grinding station in eastern India, with a capacity of around 5 million tons.

Several PE firms and strategic players submitted bids for the assets, and it was one of the latter, local conglomerate Birla Group, that won out. The merger also delivered an exit for Baring Private Equity Asia as Lafarge bought back a 14% interest in its India division. It sold the stake to the GP two years earlier (reportedly with a put-call option included) as part of an attempt to reduce group-wide debt.

Most private equity firms have been dependent on bankers for deal flow but in this sensitive area, most deals will be proprietary in nature. It is about finding elegant and private solutions for families that are overleveraged - Manish Kejriwal

Such divestments are expected to become more commonplace in India as local companies pick up the habits of their multinational brethren, driven by a combination of financial expediency and strategic rationale. However, as the Lafarge situation indicates, corporate players with deep pockets pose a strong competitive threat to private equity firms. For financial investors, timing and asset selection are crucial.

Buyouts are a rare commodity in India, with roughly half of the deals announced in 2014 falling into the growth and pre-IPO category - a consistent story over the past decade. However, control transactions are on the rise. AVCJ Research has records of 59 between 2012 and 2014, more than the combined total for the previous five years. Carve-outs of businesses from larger groups are contributing to this trend.

"It is becoming much more commonplace than it was in the past," says Manish Kejriwal, managing partner at Kedaara Capital. "There are a variety of reasons for this. For example, the large industrial houses, particularly those in commodities and infrastructure, are deleveraging their balance sheets and focusing on their core businesses. A resulting corollary is the disposal of unrelated businesses."

Dhanpal Jhaveri, managing partner for private equity at Everstone Capital, notes that control deals make up half his firm's deal flow and a good percentage of those are corporate divestments. "Relative to what the situation was 2-3 years ago, the deal flow has gone up several times," he says.

The home front

Everstone has announced two carve-outs this year: it bought Aon Hewitt's Asia Pacific payroll business, much of which is based in India; and Hindustan Unilever's bread and bakery business. Both of these were divestments by foreign companies that appointed banks to run sale processes, but industry participants also claim to be seeing more activity from domestic players as well. Historical reservations about selling off businesses appear to be abating.

Industrial conglomerate Larsen & Toubro (L&T) is a high-profile example. The company has sold off minority stakes in several businesses in the last year or so. Its executive chairman has admitted that certain divisions, particularly asset-heavy ones, may need to be exited completely in order to simplify group operations and improve return on equity.

It was reported that potential buyers were sounded out for L&T's valves and alloys businesses, although no transactions have resulted. One source notes that an auto wire harnessing manufacturing asset was also put up for sale, prompting interest from private equity and strategic players. The deal didn't happen because no one was willing to meet the seller's valuation expectations.

"You see large groups once in a while coming to the market and trying to cut off the tail of these very small businesses that are quite decent in size for private equity to acquire," says Vikram Utamsingh, co-head of India at Alvarez & Marsal. "This is a slow trend and it will emerge over time."

In other situations, divestments are not necessarily a matter of choice. Jaypee Group has offloaded a string of cement and power plants in the past 18 months as it attempts to service a debt burden of more than INR600 billion ($9 billion). Anil Ambani's Reliance Group is also under pressure due to high debt levels and falling stock prices, leading to Reliance Infrastructure's recent sale of a 49% stake in its electricity business to Canada's Public Sector Pension Investment Board.

The introduction of India's bankruptcy code could see further examples of this behavior. The Ministry of Finance released a proposal last month that would replace the assortment of regulations pertaining to insolvency with a single code and a new tribunal system to ease the burden on the courts. It is hoped the reforms will shorten the average 4.3 years it takes to wind up a company, according to the World Bank, and improve a debt recovery rate that is currently a paltry $0.25 on the dollar.

"The most important aspect is to allow liquidation to happen," says Everstone's Jhaveri. "It is important in situations where a company gets into stress and it makes more sense to shut it down and sell the assets rather than continue with the business. Land, for example, could be a very valuable asset that is locked up. The code provides an accelerated way to deal with it."

PE investors are looking to the code to help clear up companies that have continuously renewed their credit lines without taking meaningful steps to reduce debt. "Once you have proper laws laid out, that rolling over of debt, with the banks knowing they'll never get paid back, will stop," says Parag Saxena, CEO of New Silk Route Partners. "We should start to see some impact from the bankruptcy laws in 2017."

Several industry sources observe that more pragmatic and forward-thinking family groups are considering divestments of non-core assets in order to ensure they are not under threat when the bankruptcy code comes into force.

There is, however, no guarantee that private equity firms will acquire these unwanted businesses. In certain situations, a PE buyer might be the logical choice. For example, the selling group may want to stop the asset going to a competitor or it would like to retain control in the long-term and simply use the PE firm as a white knight to hold the asset for a few years before completing a buy-back.

If the motivating factor is to get the highest possible price via a full exit, strategic buyers with plenty of cash and the ability to factor long-term synergies into price evaluations are more likely to prevail.

Sensitive issues

Another consideration is the complexity and sensitivity of transactions. "Carve-outs take a long time to do," says Gautham Radhakrishnan, a partner at Tata Opportunities Fund (TOF). "There are a lot of technical points, not least tax, regulatory and legal concerns, and then you have to back a management team that has done more than just serve a parent and is able to sail on its own."

As a private equity firm sponsored by Tata, TOF is in a unique position. It has visibility into the Tata group of companies and can therefore identify situations in which carve-outs might make sense. TOF also offers continuity in terms of Tata's high standards of governance, ethics and corporate culture, which reassures any Tata or non-Tata seller that TOF will behave responsibly. Radhakrishnan observes there are perhaps many "softer elements at play" in maintaining relationships in carve-outs that are more significant in an Indian context than in the West.

This sensitivity has a further impact on how deals are sourced. While some groups will want to run a process in order to get proper price discovery, others are more circumspect and so the onus is on the private equity firm to make the running. The GP must approach the parent company, outline the challenges it faces, and show how private equity can deliver a mutually beneficial solution.

"The real deals will be done where a private equity firm is very close to the specific industrial group or relevant family," says Kedaara's Kejriwal. "Most private equity firms have been dependent on bankers for deal flow but in this sensitive area, most deals will be proprietary in nature. It is about finding elegant and private solutions for families that are overleveraged."

Trust is a factor in this context, but so too is competence. The private equity firm's pitch is usually about the value it can create through a control transaction, which in turn places emphasis on operational capabilities. It is therefore no coincidence that Everstone's two carve-outs this year focused on sectors in which it claims to have particular expertise: business services and consumer.

"If PE firms are looking at carve-outs they would look at sectors in which they have bandwidth and experience," adds Menon Raghubir, a partner at law firm Shardul Amarchand Mangaldas & Co.

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• Topics
• Buyouts
• South Asia
• GPs
• buyout
• India
• GPs
• Tata Capital
• Everstone Capital
• Kedaara Capital